Debt crises and New Zealand

Increasing concern around the size of sovereign debt in Europe, combined with surprisingly weak US economic data has led to a sudden sharp drop in equities since in recent weeks. These declines have intensified recently, with the S&P 500 now down 13% since July 22.

The key question this raises is: "if there is another financial crisis how will this impact on New Zealand"?

There are three main areas where concerns overseas can have an impact on the New Zealand economy: Trade volumes/prices, confidence, and financial market conditions. After looking at these our conclusions are:

Household spending will not rise as quickly as we expected, but not fall

The price for the goods New Zealand sells will stay strong

Financial conditions will tighten again, ensuring that it remains difficult for some firms to borrow

We will discuss the reasons why below.

Trade volumes and prices safe for now

The most obvious area where a new financial crisis could impact on New Zealand is through export markets. With growth in Europe and the US lower, the demand for New Zealand’s goods and services would decline thereby lowering the price, and reducing the amount we can sell to those countries.

New Zealand is small open economy that sells soft commodities. As a result, the products we sell overseas can easily be displaced by competitors or can easily displace other sellers of milk, forestry, and meat products.

In such an environment New Zealand would still be able the goods that it produced overseas implying that the direct decline in GDP would not be too large. However, the price we receive for these goods would fall sharply reducing incomes, and thereby leading to lower spending by New Zealanders.

There has been talk of commodity prices falling sharply. In the last two weeks, copper, nickel, and oil prices have all eased back markedly. However, with stockpiles of these resources very high their price is very responsive to changes in the outlook for economic conditions.

Encouragingly, so far we haven’t seen any direct downward pressure on the price of many of the commodities New Zealand sells overseas.

Unless the crisis intensifies significantly, New Zealand’s commodity prices will continue to be supported by drought conditions overseas, and in the longer term the rising cost of feed and changes to industrial policy overseas should keep prices elevated. As a result, we don’t expect the current crisis to have a big impact on commodity prices.

The importance of confidence

The current crisis in financial markets can also be expected to have an impact on confidence, and to increase uncertainty. This time last year, the uncertainty regarding the Euro region made consumers cautious about spending which helped to drive an economic slowdown.

However, consumers have been rebuilding their balance sheets in recent years and the sharp increase in consumer spending since January appears to have come solely from rising incomes, with credit card and bank debt staying close to unchanged.

As a result of this, if consumers do remain cautious due to uncertainty overseas we expect them to just limit future increases in spending rather than cutting spending from current levels.

Another area where confidence will be strongly hit by recent events is among exporters with weaker demand from the US and Europe causing concern. Although the recent decline in the exchange rate will buffer any pain, uncertainty about global growth will limit investment and production by New Zealand exporters.

Tightness in financial market conditions ahead

When Lehman Brothers collapsed in September 2008, the global financial system ground to a halt. The loss of Lehman Brothers had a huge impact on trust in the financial system and people were unwilling to lend to each other.

However, this time is different. The financial concerns this time are around government governments that are largely still solvent. As a result, the financial market is not going to freeze up entirely and credit default swaps for our banks (which capture the cost of insuring against the default on a loan) remain nearly 50 basis points below their March 2009 peaks.

Even so, the uncertainty regarding any solution in Europe and concerns about growth in the US have combined to make investors less willing to take on risk. This is a factor that has already pushed up the price of credit default swaps by nearly 40 basis points since the end of July. As a result, they and are higher than they were when Ireland was struggling with a debt crisis in late 2010.

With bank funding in New Zealand now more closely pegged to domestic savings it doesn’t appear likely that there will be significant contraction in credit available in the coming months. Unlike the Lehman Brother’s crisis, there is more likely to be insufficient demand for loans than a restriction in supply during the rest of 2011.

However, tighter access to credit will strangle off the possibility of a stronger than expected recovery in the coming quarters implying that New Zealand economic growth will remain limited.

Summing up

We are not of the view that recent events will completely derail the New Zealand economy in the same way that the Lehman Brothers crisis did.

However, given the elevated level of uncertainty around the world, credit conditions are once again expected to get tougher ensuring that raising capital and funding way remain difficult foursome projects in the near term.

Furthermore, continuing uncertainty about the global recovery will make both households and consumers nervous, ensuring that spending restraint continues heading into 2012.

In terms of commodity prices are not expected to fall far with many of the underlying fundamental drivers of elevated New Zealand export prices remaining unaffected by the recent crisis.

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